General Mathematics

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Simple and Compound Interest and Simple and General Annuities - Part 002

Simple and Compound Interest and Simple and

General Annuities – Part 002

This module tackles topics on Simple and Compound Interest as well as

Simple and General Annuities.
Course Module Objectives:
At the end of this module, the learner should be able to:
1. Distinguish between simple and general annuities
2. Find the future value and present value of both simple annuities and
general annuities
3. Calculate the fair market value of a cash flow stream that includes an
annuity
4. Calculate the present value and period of deferral and deferred annuity
Give instances when people normally pay in installments. Ask your parent,
aunt, uncles or even brothers or sisters who have been working and have
experiences in paying for commodities or services in installment.

Simple and General Annuities

Review:

Simple annuity is where compounding and payment period happen at the

same time.
General annuity is where the payment is not the same as the interest
compounding period.

Terminologies:

Before we go on to further discussion on Annuities, let us define terms which

will be used in the discussion.
1. Annuity – a sequence of payments made at equal (or fixed) intervals or
periods of time.
2. Payment interval – the time between successive payments
3. Term of annuity ( ) – time between the first and the last payment.
4. Regular or periodic payment ( ) – the amount of each payment.
5. Future Value ( ) – sum of future values of all payments to be made during
the full term.

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 6. Present Value ( ) – sum of present values of all the payments to be made
during the full term.
Visually, you may see an annuity as illustrated in the diagram below:

P F
R R R R … R

P is the present value of the annuity, R’s would be the successive payments
and F is the future value of the annuity at the end of the term. The term is
represented by the straight line below the R’s in the figure.
In a simple annuity, the payment and the compounding happens at the same
time.
Example#1:
Suppose your Mom would like to save Php 2,000.00 at the end of each month
for 1 year in a fund that gives 12% compounded monthly. How much is the
amount or future value of her savings after the end of her term of annuity?
This is an example of a simple annuity as the payments of your Mom will
coincide with the payment of interest on her investment.
Let us look at another example:
Example #2:
Suppose your Mom would like to save Php 2,000.00 at the end of each month
for 1 year for a fund that gives 12%compounded quarterly. How much is the
amount or future value of her savings after the end of her term of annuity?
This is a general annuity as the payment is monthly but payment of interest
is per quarter (every three months).

Present and Future Values

Simple Annuity
Computation for the future value of simple annuity is based on the formula:

where:

Let us go back to the first example:

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Simple and Compound Interest and Simple and General Annuities - Part 002

Your Mom wishes to save Php 2,000.00 at end of each month. This is out R.
Interest rate per period is 12% per annumand the number of payments is 12
as she wishes to save for 12 months.
When computing for an annuity value, you must remember that it is not just
a simple interest computation as in an investment in a simple interest fund,
the principal is a lump sum and interests are computed based on it
(principal). In an annuity, the monthly payments are considered as separate
investments.
Consider the following computations:

In total, your Mom would have saved Php 24,000.00 in 1 year. Your Mom’s
first payment would have earned interest for 11 months. Since the fund
compounds monthly, we use the future value formula for compound interest:

( )

where:

The other payments would use the same formula and the variable would be T
based on the payment number of the savings.
Computing for payment 1:

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 ( )

( )

In 11 months, the initial savings of Php 2,000.00 would have earned Php
231.24.
Using the formula to compute for the future value of the annuity,

where:

To compute for the Present Value of payments in a simple annuity fund, you
may use the formula:

where:

The premise of the equation is that there is "time value of money". This
means that the value of the money that you will receive on a future date
would have less value than if you receive the same amount today. Think of it
this way, it would be better to receive Php 500.00 today than receive it a year
after as the value of the Php 500.00 would have decreased.
Let us go back to Example #1:
Computing for the present value of the investment:
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Simple and Compound Interest and Simple and General Annuities - Part 002

General Annuity
In the computation for general annuity, the payment schedule is different
from the interest compounding payout. The formula is generally the same
with some adjustments on the interest rate per period.

where:

Let us look at Example #2

Suppose your Mom would like to save Php 2,000.00 at the end of each month
for 1 year for a fund that gives 12% compounded quarterly. How much is the
amount or future value of her savings after the end of her term of annuity?
1. First thing you need to do here is to calculate the number of interest
periods per compounding interval represented by C. The number of
interest periods in this problem is 4 since the fund compounds quarterly.
Solving for C,

2. Second is to determine the equivalent period rate

This interest rate will be used for the computation using the same
formula for a simple annuity. The equivalent interest is the computed
interest for the fund if the payment and the compounding interest payoff
coincide in schedule.
3.
Computing for the present value of funds in general annuity follows the same
formula for simple annuity present value with adjustments on the equivalent
interest used. Since the payment schedule and the compounding interest
payoff are not the same, you need to compute for the equivalent interest in
which the fund is treated as a simple annuity.
Computing for Example #2:

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Fair Market Value of a Cash Flow Stream
The computation of a fair market value (FMV) is an important concept in
business transactions. Although there is no straight forward formula that you
could use to compute for FMV, you need to use knowledge of business
concepts to determine FMVs.
FMV computations are used a lot in the insurance industry. Insurance agents
would normally show computations to prospective clients so that the clients
may be better assisted in making an intelligent decision on choosing a plan
they would avail of.
Let us look at an example of the use of FMV concept in making decisions.
Example #3:
Your family is thinking of selling your current house to buy a bigger house for
the growing family. Several days after the advertisement of intent to sell,
your father was offered by two persons interested on buying the property.
Offer 1: Down payment of Php 500,000.00 and a lump sum payment of Php
2,000,000.00 after 2 years.
Offer 2: Down payment of Php 500,000.00 and a monthly payment of Php
100,000.00 for 18 months.
Which of the two offers will be better to accept of the payments will have an
interest of 12% compounded monthly?
Solution:
An initial review of the problem would most probably sway you to accept
Offer #1 as it totals Php 2,500,000.00 in payment (Php 500,000.00 + Php
2,500,000.00) while Offer #1 totals Php 2,300,000.00 (Php 500,000.00 + Php
1,800,000.00). However, this is not enough information and figures to help
your parents make an intelligent decision.
Let us look at the fair market values of both the offers.
Offer 1:
Since the payments are in lump sums, you will need to use the compound
interest formula:

( )

( )
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Simple and Compound Interest and Simple and General Annuities - Part 002

Offer 2:
Since the payments are in installments, you need to treat this as an annuity.
This is a simple annuity as the payment coincides with the compounding
interest rate payoff.

From the two computation, it shows that the better option is to accept Offer
#2 as it gives your family a higher return.

Present Value and Period of Deferral and Deferred Annuity

Have you heard of a buy now pay later scheme in credit card companies?
This is an example of deferred annuity. This is a type of annuity that does not
begin until a given time interval has passed.The period of deferral is the time
between the purchase and the start of the payments for the deferred annuity.
Example 4:
Suppose you want to buy a mobile phone and you opted for the option in
which you will be paying Php 2,500.00 per month for 1 year at 9%
compounded monthly. How much is the cost of the phone now if you will be
paying at the end of the fourth month?
First thing to do is to analyze the problem so you may know what formula
you will be using.
The problem is a simple annuity as the payment schedule and the
compounding interest payoff are the same.
Next step is to treat the deferred annuity as a simple annuity to get the
present value of the commodity. In this case, a mobile phone. You need to
include the first three months of deferred period so the terms would be 15
instead of 12.

This is the present value of the phone if you will be starting to pay
immediately.
Since the scheme is a deferred annuity, you need to compute for the present
value of the phone within the first three months of artificial payments (no
payments being made)

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 Next, subtract the present value of the artificial payments from the first
present value computed.

In summary, the formula for the present value of a deferred annuity is:

where:

Activities and Exercises

Interview an insurance agent. Ask him/her about the insurance offers they
have for clients. Use the lessons you have learned here to understand and
analyze the offers of the agent. Make an intelligent decision on which plan
would be more beneficial. Discuss what you have learned in class.

References
Albay, Eduard M., et al., (2016). General Mathematics. Makati City: Diwa
Learning Systems, Inc.